Prashant Kumar, CCIM - Founder, MyRealtyGains

Thomas Castelli is a Tax Strategist and real estate investor, who helps other real estate investors keep more of their hard-earned dollars in their pockets and out of the government’s.

What You’re Going to Learn:

How limited is Partner Investing? How should limited partner define their tax strategy?

What is Limited Partner Investing? How should limited partner define their tax strategy?
How long does it take to be a Real Estate Professional and Especially for someone doing a W2 job?
What are the different asset classes in Multifamily Real Estate?
What are the Passive strategies you propose for W2 folks who have a working spouse?

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Show Highlights

What is Limited Partner Investing? How should limited partner define their tax strategy?

Prashant Kumar, CCIM – How limited is Partner Investing? How should limited partner define their tax strategy?

Thomas Castelli – The first thing to understand as a Passive Investor is how income is taxed. I think we should start there. If you’re in tech and you have a high-paying technology job, your earnings are being taxed as ordinary income, which can be taxed anywhere between zero and 37%, which can be quite high and that’s the federal level. There’s also the state tax.

If you work and you live in a state that’s state tax, like California that income is a bucket of income, and your quote-unquote earned income is pretty difficult to shelter from taxes. When it comes to Real Estate. It is also taxed ordinary income rates, again from 0 to 37. However, the good news with Real Estate is it’s really easy to shelter your rental income and capital gains from the sale of Rental Real Estate from tax. I’m going to break down how to do that right now. So the reason why it’s so easy to do this is that there’s something called depreciation. It’s a non-cash expense that Real Estate businesses have. If you have a rental property, you’re going to have a depreciation expense and this expense can create a tax loss for you even though you might generate positive cash flow. It kind of illustrates what it looks like.

Let me give you an example. Let’s just say you earn $10,000 in rental income. Just for the sake of argument, keep it easy with $10,000. Well, you might have $6,000 of hard expenses, and that’s money that leaves your pocket. So what I mean by that, is you’re going to have advertising expenses, you’re going to have property management expenses, you’re going to have utilities, property tax, mortgage, interest, the list goes on, like repairs and maintenance. All these expenses are things that leave your pocket. However, the depreciation expense that I’m talking about here does not leave money, does not leave your pocket, but it shows up on your PNL anyway.

So back to my example. $10,000 of rental income, and $6,000 of hard expenses that leave your pocket. Now, let’s say you have a $5,000 depreciation expense. Well, now you have a negative $1,000 net loss on your tax loss rather than for this rental business, right? So basically, you pocketed $4,000 in cash flow, but you have a tax loss of $1,000. So that means that A, you’re not paying any tax on your rental income, so you just made $4,000 but not paying any tax on it.

That’s the first part of it. Part B, as you now have a $1,000 loss. what happens to this loss? Well, this loss can offset other rental income that you may have in that same year that you get the loss or gains on the sale of a rental property that you may have. Now, if you do not have any of that in that particular year, well, this $1,000 loss in our example here is going to get carried forward to future years, and that $1,000 can be used to offset rental income in the future and future years or gains from the sale of real estate in the future. So that is first and foremost how the benefits of real estate work. And it’s at its core, your ability to shelter income and capital gains from tax.

Prashant Kumar, CCIM – What you are saying is, even if you are making money in Real Estate, the $4,000 you have made in the real estate, you are not paying taxes. In addition to that, in your example, you have an additional loss that you can either offset the other real estate income and potentially, if there’s no other real estate income that gets carried from this year to the next year, hopefully, hopefully in the next year, it can help you to offset some Real Estate gains.

At what point, the loss from Real Estate Investing can be depreciated against W2 income?

Prashant Kumar, CCIM – At what point this Real Estate loss can be depreciated against your W2 income? I know there are a lot of concepts, and I would like to hear from you. At what point?

Thomas Castelli – There are a few different ways to do that. I’ll take it from the passive angle first if you’re a Passive Investor, the way that you’re going to be able to do that is when you sell the property, right. That loss is going to be quote-unquote, unlocked. So it’s no longer going to be necessarily passive in the year you sell the property that loss is first going to offset any capital gains from the sale of that property then any passive income you have from any other rental properties you have. Now, if that loss still exceeds if there’s still a loss after those things happen, then at that point, that loss can offset your W two-income. So that is one way that can happen.

I got to be honest, in recent years with the way the market is running up mostly. There are not enough passive losses after offsetting your capital gains from the sale to offset your W2 incomes. But that is one way it can happen.

Now, there’s another way that this can be done and this is more on the active side of the business to be fair but it’s called the Real Estate Professional status. The way the Real Estate professional status works is if you work full time in Real Estate to qualify you to need to spend more than 750 hours in a real property trader business and more than half of your total working time. If you do that and then you materially participate in your rentals, which is pretty much being actively involved in the operations of the properties, then you’re going to be able to take that loss. That loss is not going to be passive anymore. That loss will be now non-passive. And that non-passive loss can now offset your W2 or active income from another business or pretty much any type of income that you have at that point, if you’re you qualify as a real estate professional like I just mentioned, that loss can do that for you. So those are kind of the two ways to do it when you’re talking about Real Estate.

How long does it take to be a Real Estate Professional and Especially for someone doing a W2 job?

Prashant Kumar, CCIM – What point one can become a Real Estate professional. How long does it take for someone to become a Real Estate professional? Even if they are doing a w two job? What is the progression? I know some people who just quit their job. They can become Real Estate professionals because they don’t have W2 jobs But most of the folks we are talking about here have W2 jobs. And what are the better ways? What are the ways they can become real estate professionals?

Thomas Castelli – Let me start with this, the first thing is the IRS considers a full-time job and that’s their benchmark. It’s about 40 hours per week, right? So to qualify, again, you need to spend more than 50% of your total working time and it’s going to be very difficult, if not impossible, to qualify when you have a full-time job because to do that, to prove to the IRS that you did work more than 50% of the time, you’d have to work 20 hours in the Real Estate business on top of your full-time job. You’re talking about 81 hours per week of work for 52 weeks. The IRS typically is not going to agree with you there. The Real Estate professional status is one of the most highly litigated portions of the tax code, with over 500 tax court cases, and in all but one tax court case, one person who had a W2 job, full-time W2 jobs qualify and that was an interesting case because the person was a pilot and they were able to prove that they only work like 1180 hours per week, I think the number somewhere around there, and that they did spend more than half their total working time in Real Estate so that was the one instance they were able to kind of get away with that. But in nine out of ten times or more than that, frankly, you’re not going to be able to do when you have a W2 job but What you can do is if your spouse says you have a spouse and your spouse is working part-time, or your spouse does not work at all in a different business, then they can have some rental properties that you have maybe on the side that you manage.

If they can qualify as a Real Estate Professional, well, because you’re married, when you file your tax return, if you file married filing joints, well, then you both are going to be Real Estate Professionals.

There’s one strategy where one spouse, say, maybe has a high tech job with high income and this actually happens all the time, and then their spouse can manage more portfolio of rental properties, qualify as a Real Estate professional, and then use the losses from those rental properties against the high tech income and reduce their tax liability, in some cases by tens of thousands of dollars. So that is one way to do it to have your spouse qualify.

Prashant Kumar, CCIM – Awesome. That’s a very good tip and it’s all legal. It is very difficult for a W2 person who’s working 40 hours a week to get the RPS status, Real Estate professional status. However, there could be a scenario where your spouse may be working part-time and she may qualify for a Real estate professional easily either working part-time or she’s a homemaker, but she can qualify as a Real estate professional. And that way, the whole income of the family, an active income of the family is available if there are losses from the real estate business due to depreciation.

What are the different asset classes in Multifamily Real Estate?

Prashant Kumar, CCIM – What are the different asset classes do you think are sort of available for our limited partners where they can get the maximum for their money?

Thomas Castelli – There are other businesses you can invest in with a limited partner. ATMs are popular amongst investors. They have a good cash flow for those businesses and have high amounts of depreciation. Effectively all the ATMs are going to qualify for 100% bonus depreciation. When you’re investing in ATMs you’re going to get big passive losses passed back to you and those can be used to offset your Real Estate income and vice versa. So that’s a very popular asset class. Car washes are another popular one. We see a lot. What we’re talking about today, residential, and commercial real estate can also be powerful. I mean those are the ones that come to mind. But any business that you invest in, that’s a partnership and you’re a limited partner, you’re just putting the money up can be good. Assuming the underlying business is good, you.

What are the Passive strategies you propose for W2 folks who have a working spouse?

Prashant Kumar, CCIM – What are the strategies you propose for national W2 folks who are husband and wife and they are working? What are the different strategies you propose?

Thomas Castelli – I’m going to go with the active, just a little bit on the active side, just so we cover that, and then I’ll go into the passive side. There’s another strategy out there called the short-term rental loophole.

Now to back it up just a little bit, all rental activities are passive under the tax code, like we’ve kind of just been mentioning unless you’re a Real Estate professional. However, there is a special rule that if you have a property with an average stay of seven days or less, then it’s not considered a quote-unquote rental activity anymore. It’s just treated as a normal business and when it’s treated as a normal business, you do not need to qualify as a Real Estate professional to take losses. All you need to do is prove that you materially participated in the activity and to do that, you could meet one of seven tests. However, there are three that most people need to be concerned about, and I’ll run through those right now. So the first one is you do substantially everything for the activity, and that means that you’re doing almost everything for the short-term rental and no one else is helping you outside of you and your spouse. That’s the first one.

The second one is you spend more than 100 hours on the activity and no one other individual spends more time than you. This is a popular one because a lot of people use this test specifically. After all, you could still have cleaners come to clean your short-term rental property in between stays and still keep them under the time you spend.

The next one is you spend more than 500 hours on the activity. If you spend more than 500 hours on your short-term rentals, then they’re nonpassive. And that’s it. It’s just that simple. It doesn’t matter how much time anybody else spends. So if you’re able to maintain an average day of seven days or less on a short-term rental property and meet one of these three tests I just mentioned, then your losses from the short-term rental will be non-passive and then they can offset your active income as well. So that’s another strategy people can use because the bar is much lower, you don’t need to spend more than half your total working time or even 750 hours in the real estate business to make that work.

Prashant Kumar, CCIM – It seems like short-term Real Estate rental is opening up the space for a lot of professionals, those who are in the Airbnb space, and they can achieve all the depreciation benefits without going through the hassle of becoming RPS real estate professional. So the active income generated by the Airbnb kind of model or depreciation generated from that model can offset any W2 income for husband and wife. As long as the husband and wife have spent some time 100 hours. All the three tests that you just mentioned, or if they spent more than 500 hours, then obviously the whole thing’s can be I mean, the test passes.